Macroeconomic and financial market commentary

The Keynesians, the Pavlovians, and other tribes.

Staunch Austrian Economists argue that a known quote, attributed to Milton Friedman in 1965, was taken out of context. For most, he signed in for Keynesianism when he coined the phrase “We are all Keynesians now”. Well, maybe he did. But such enthusiasm does not jibe with the fact that, three years later, he felt the need to fine tune his views on the issue. He then stated that what he really meant was that “We all use the Keynesian language and apparatus; (but) … none of us any longer accepts the initial Keynesian conclusions.”

That goes a long way to prove that Keynesianism’s obsolescence has roots in the very distant past! Fifty years ago, a key economist like Milton Friedman felt the urge to distance himself from the “Keynesian initial conclusions”. Not that he was a stand-alone dissenter. For that matter, Von Hayek had used much stronger words to underline the major economic shortcomings of Keynesianism. “Bon-Vivantism” or “Shortermism” might have been a more accurate depiction of the discipline’s content.

Unsurprisingly, it was only the initial, tweetable quote, that remained in the minds of the economists of the time. Fast forward to 1971, and Richard Nixon wasn’t in the mood for subtleties at the time. Reportedly talking off camera, he told an ABC news reporter “he had also become a Keynesian in economics”. Off camera, or not, he was just talking his book. He had no choice but to officially embrace Keynesianism, and the leeway provided by the indiscriminate use of monetary and fiscal indulgence it supported. Sure enough, six months later he suspended the USD convertibility into gold, effectively defaulting on the gold peg of the, from then on, reserve fiat currency of the global economy.

Regardless of the need to cut the peg short at the time (defaulting in full was the only other option), nobody in the Austrian School of Economics can pardon the fact that he failed to anchor the currency to some other alternative peg (I stand for a peg of the monetary base to “Gross Output”, with a 2% flexibility band on each side). From then on, money printing was to be unlimited in nature and relied exclusively on the collective decision of the FOMC, and that of the other Politburos. Keynesianism provided a free entry into the wilderness of limitless public deficits, ever expanding debt levels, boundless CB balance sheets, and manipulated interest rates.

Taking his cue from that doctrine, Ben Bernanke pondered the merits of the modern technology called “printing press”, together with the use of helicopters to spread out the money. That infamous speech earned him the deserved nickname of “Heli-Ben” -and a long tenure as the chair of the Federal Reserve. From then on, the world has been run on the premise of full conversion to the Keynesian religion.

A couple of decades later, and we all ought to be enthusiastic Keynesian converts by now. If Nixon had no other choice at the time, just think about what our real options are, today! Even if we wished to abandon the Keynesian discipline we have long gone way past the point of no return. We are truly stuck.

Piles of debt effectively impede moving forward, or even backward, with fiscal or monetary recipes, for much longer.

Outrageous inequality has been enabled by financial repression (punishing savers to enrich investors in the top wealth tier), and fostered by the availability of ever cheaper debt, with the aim of subsidizing faltering aggregate demand. Obviously, technological change hasn’t helped either. Ditto for educational levels, nearly everywhere. Top chart with the daunting wealth pyramid, courtesy of Gordon Long.

Supply side neglect has rendered a substantial part of our goods and services produce, obsolete, or environmentally unsustainable.

Keynesian public spending has bloated government sectors to more than 50% of GDP in some countries. European Labor Unions think it is not enough!

Unlimited liquidity has generated bubbles and inefficient pricing in most markets.

Zero financial costs for borrowing has favored a gearing up of most non-financial conglomerates, and a desperate search for yield (read return) by most investors -at all costs.

Yet we keep switching from monetary to fiscal Keynesian policies, suggesting escape velocity came real close with QE, or, of late, suggesting that fiscal reflation would solve the previously described pathology of our global economy business model. An endless continuum of policy mistakes. For how long?

It is impossible to time stamp something so dependent on human decisions at CB politburos. The odds are always heavily against you if you are trying to time the advent of Armaggedon. And the odds are crucial to long term success in investment (and in life as well). They are always more relevant than we care to admit. We traders like to call them wisdom when we are right, and bad luck when we got it wrong. But it’s just about odds most of the time, so you want them to be on your side. I will keep trying to time Armaggedon -but I will preserve my capital at all costs. I keep on holding my ground there, but barely. It’s tough to be a bear in the era of the Central Banker.

About the Pavlovians.

Most might be Keynesian, but I think today they are clearly outnumbered by the crowded ranks of the Pavlovian. Pavlov was, as everybody knows, a Nobel prize winner in Medicine, and a contemporary of John Maynard Keynes. And no less famous. His Pavlovian dogs are more present in actual literature than Leonardo da Vinci’s “Monna Lisa”. And not only in psychology, but just as well in finance. Most investors have become Pavlovian by now. Not all though, unfortunate for some of us as it is, not everybody has had the time or the intention to master that discipline. Pavlovian investors are all deeply in the money by now, “surtout” the most disciplined ones. Those who buy the dip faster, get themselves a Porsche Panamera (my dream car). No wonder the strength of Pavlovian conditioning grows by the hour.

It took investors three days to react to CB provided Pavlovian stimulus after Brexit. It took just three hours to turn everything around after the Trumpocalypse moment. And most recently, it only took three minutes for investors to react positively to, not only a neutral but a negatively perceived stimulus (Italbust? Italeave?). Life has never been easier at POMO desks. I am thinking of applying for one of those jobs myself. I wonder what the pay is like.

Current investor reaction to worldwide events seriously improves Ivan Petrovitch Pavlov’s experimentation with dogs. Lest we forget, I will reiterate today that he only managed to condition reactions to a “bell ringing”, neutral kind of stimulus. CB’s psychology departments have long left him, and Sigmund Freud, well behind: now investors can react positively to negative stimulus! We’ve gone all the way from food motivation (Pavlov) to sexual instincts (Freud), and finally to money making (CB’s), as valid drivers for human conduct. Except for some refugees in northern Europe, that still crave for sex (sadly, of the violent kind), it’s money that makes the world go around today. In our financial world, just “follow the leader”, buy the dip faster yet, and you will be rewarded. We do live interesting times.

Market update.

It really surprised me to read some recent remarks by Claudio Borio (BIS), explaining he had expected a quiet fourth quarter in the markets, this year. Paraphrasing Oscar Wilde, he concludes investor carelessness generated the U-turns and wild volatility. I disagree. I think most fund managers are anything but careless now. To borrow from Pink Floyd’s utterance, we all sleep on our toes -and, frankly, we don’t get much sleep nowadays. I was not expecting calm waters, and I don’t believe odds favor considering market volatility the consequence of wrong positioning prior to the relevant events of the year. Does he mean we fund managers got it wrong three times out of three (Brexit, Trumpocalypse and Italeave implicit vote) this year? No way we might have achieved that -even if we tried.

The problem runs much deeper. Starved for yield, investors crowd every single trade, as soon as it is available, and supported by the media and sell-side narrative. Unanchored by plain coupon or dividend yield supported rates of return, quants, hedgies and active managers rock the markets with the synchronicity of their moves. Excess liquidity pumped by CBs, together with ZIRP and the promise of more NIRP to come, generated the deflationary boom post-Brexit, with fresh lows in yield for all long term bonds. That very same money turned around, and bought banks and cyclicals after Trump, dumping bonds in the process. All trades are crowded now. The smart money is always piling on to the same side of the two or three best risk-reward trades available.

The Pavlovians took good care of the market reaction to the Italian issue. Mario Dragui had made it clear to all. He would not just stand aside and watch any market correction. He is Italian. Career risk, and the proximity of the end of the year, pushed fund managers to rebalance portfolios towards the new paradigm (reflation). It will happen again: I expect a deep retracement (of at least part of the move) before the end of January.

This is an environment for passive management (ETF’s), and/or Keynesian believers (those that think this “reflationary” trade is based on realities and anticipate a main street overheat next year) to whom I wish good luck. The alternative option is investing with Pavlovian fund managers (non-aligned, no nonsense, but-the-dip pragmatic managers). But they carry a lot of systemic risk in their portfolios!

Hedge fund managers, and uncommon sense investors, do well enough if we manage to survive. We are having a rough time. The post Italian referendum move is a case in point. Their ten year credit spread with the Bund, collapsed from close to 195 bps to 156 bps in a matter of days. Their stock market saw a sizeable up move, together with the rest. The EURUSD cross went 2%+ higher (euro was up initially). Italian Banks? Taxpayer debt will end clearing up the mess. Sovereign debt concerns? Who cares. Anybody trading that scenario with some rationality would have lost money. Standing aside, passively following the index, buying the dip, or playing the momentum trade, were valid approaches. But no thinking allowed -for your own sake!

Investors think they will all live happily ever after. Maybe, but I can’t share the enthusiasm. Regardless, we must always learn the lessons of recent history: whatever the news, think positive! Well, positive thinking, love, hope and faith are good advice for life, but I am not ready to use them as an investment strategy. Most are. There is always a positive spin to be found for just about all kinds of news. Don’t worry, POMO desks will find the way to transmit it. Brexit, Trumpocalypse, Italeave? Done with. Something new in the offing?

Investment Outlook.

The trillion-dollar questions, right now, are: is this massive, reflationary, equity and energy rally, sustainable? And, will bonds continue to be dumped, or shall we see a strong bounce in their market value (Edwards, Rosenberg)? Two ideas come to mind when considering the appropriate answer.

For the first time in my professional life, during this year 2016 now ending, I have begun to question if it is the narrative that moves the prices, or if it now works the other way around. Undoubtedly psychologically influenced by Eugene Fama’s EMH, I had always thought narratives moved markets, and that the key to success was being faster than the rest at finding out what the new narrative was going to be. But for 2016 at least, market moves have relentlessly preceded narratives.

We really don’t know what’s going on. Honest to the point of bluntness, this is what Claudio Borio had to say about the latest market moves (recently released BIS quarterly report).

“we do not quite fully understand the cause of such unusual price moves … “

Today, narratives are mostly built “post-mortem” by the securities industry. They are no better at knowing what’s going on inside those moves, than most readers of this post. We are all confused, but only some confess to it.

Okay, if the narrative does not move the markets, what does? It is a complex answer that has already been suggested in the preceding paragraphs. Suppressing risk free rates of return was not to be a measure without side effects. None of them is. Particularly when combined with lots of liquidity. Anybody who sails, or knows a word about ships, knows that the hull must be built with passive and active stabilizers meant for strong seas navigation. Heeling to port or starboard, in heavy seas, can endanger the boat. Stability is lost when, for any reason, the hull gets flooded. Liquids move freely towards the port or starboard side of the vessel when it heels, aggravating the move.

We have generated lots of liquidity in the financial system. And we have starved it, effectively depriving it of yield, or income. Productive investment is not deemed viable by the holders of liquidity, because of the chronic state of aggregate demand (stagnant CAPEX). Financial investment with low risk portfolios, is no alternative, because it generates zero or negative returns. That liquidity is homeless, and roaming around the market looking for a prey (trade). It is going to move faster and faster with the markets, as Fund managers pile into every occasion where they perceive there is money to be made -or a loss to be prevented. Excess liquidity will increasingly roll the boat -until, at some point, it capsizes. Like a sage surfer, you’ve just got to wait for the right wave. We are losing control.

This will get worse, not better, until liquidity can be deployed into viable investments with a decent rate of return. Homeless liquidity enhances the normal moves that are essential to price discovery, due to the variable nature of economic data. An uptick in inflation expectations based on crude prices and unit labour costs, has been amplified to a bond deluge. Yes, inflation has reared its ugly head, but I doubt it will be sustainable without a major global fiscal spending program, and the necessary printing to finance it (Trump is not going to get it from Congress).

First quarter inflationary data is already baked in the cake -due to energy price comparison with last year. But, if we get a couple of low inflation reads after the first quarter of 2017, liquidity might generate similar moves in the other direction. Other minor adjustments will be accounted for, by markets -and every adjustment will feed on itself due to liquidity sloshing around.

One thing is clear to me: one way or another, rates have to go up and there will be no return to financial stability until they help soak up homeless liquidity. If liquidity reigns, unpredictable, intense swings will continue, up to the very end of this QE and ZIRP enabled global financial bubble. As I see it, rates are currently going up not mainly because of the actual reflationary risk, but, more severely, because it is the risk of a repricing of interest rates that cannot be accepted at such low levels of return (a 40bps yield for a 10Y bund, does not provide much margin to finance possible capital losses due to a steepening or lifting of the curve).

Buying a ten year bond, for no yield, is only viable if the CB for that currency guarantees no capital losses. You take the put out, and bonds dive. And central banks explicitly pulled out this summer (the BOJ being the most explicit about its curve steepening new policies). I suggested this might be the outcome in my post “A subtle, self restrained, change of heart”. Chinese selling of Treasuries has not helped either.

This is indeed a reflationary scare in bonds, and a reflationary unleashing of animal spirits in equity and consumer sentiment. Crude market developments help the cause. But it will not last long. Wait, that sounds dismissive! But I assure you it is not a light talk conclusion. I repeatedly wrote, more than two years ago, that QE would not work. Most thought otherwise. Last march I openly asserted that NIRP would not work. Neither did, and the BOJ backpedaled out of further NIRP expectations, a couple of months later. I might be wrong this third time -of course. But I think this reflationary scare will not be better off, and will not allow the economy to achieve escape velocity. I use the same underlying reasoning I used in the preceding scenarios. It served me well. Nothing will work, until we fix aggregate demand working on the supply side (Say).

Second. Depending on the calendar of events, we will, or will not, see low interest rates again. If this reflationary acceleration wears off without any black swan events, or a major repricing in the financial markets, the deflationary forces will take bond yields down again retracing at least 50% of the last move in yields (below 2% in the ten year treasuries). But if the financial system implodes, because of the tensions induced by the surge in rates, or the increasingly treacherous instability of bond and equity markets, we will never see low yields again.

Post defaults and a debt clean up, capital will not come cheap. Think of risk free rates above 1% and decently steep curves (2Y-10Y above 180 bps at least). I don’t buy Lael Brainard’s biased writings about the descent of the Wicksellian, natural rate of interest. I’ll take the other side of that trade. Capital will be scarce once we clean up our bloated global, non-consolidated balance sheet.

In any event, here’s my advice to other money managers.

We must reduce our VaR, to adjust to more frequent market routs and decreased financial price stability.

We want to be careful about falling all in, to a relentless USD rally expectation. I have been a dollar bull for some time, but I do not think the trade has a lot of upside left. Parity for the euro, and the 120 to 125 level for the Yen are, most likely, the best scenario (leaving aside a possible euro implosion). I would be more cautious calling the end in the USDCNH cross move. A 7.25 target looks feasible to me (in due time, and after some much needed short term stability).

We must not rely on a solid bounce in bond prices -that is unlikely to happen before the move up in yields is finished. I see the 10Y treasury yielding 3% or thereabouts, and some modest flattening of the 10-30 year spread. We might go back to ten year yields below 2% after that. Maybe before, but if, and only if, equity markets tank. Money would swiftly flow back into bonds, further dumping equities in the process.

Europe is unlikely to survive 2017. I leave it up to you to think of the brutal consequences. It is the elephant in the room that European politicians are unable to see. The chart underneath is slightly outdated, but things have not improved since last August.

Company profits have not turned around. One quarter (3Q 2016 in the USA), a trend does not make. Unit labour costs will continue to be tensioned by the shrinking pool of skilled workers, and corporate net margins will continue to erode. I do not see sales making up for the downside in margins.

Global GDP growth will prove evanescent. Trump is a negative shock, and time will deliver the message beyond any reasonable doubt. Enjoy the reflationary rally in the meantime.

I cut my residual equity shorts at 2210, in the December S&P futures contract. My conviction has not changed (see chart below), but capital preservation is a must. Hussman and Horseman’s analysts are right: equity markets are mostly a strong sell. But there’s no need to fight the tape!

First shorts to implement again, when the timing is right, will be European Banks (the Eurostoxx Bank index), trading as I write, around the 117 level. European banks are not off the hook because of the steepening of the yield curve. It just ain’t that easy. I wish it were. I’d just go long (making money is a lot easier that way)!

That’s my take on the current situation. I hope I got it right, but, you know how this game is played. No guarantees. Thanks for your reading. I have nothing else than my ego at stake in this blog, so I enjoy writing it, even if it implies consistently raining on the parade. Right or wrong, I am honest and straightforward with you, and that is not something most bloggers can take pride of.

Lastly, regardless of the pitiful state of our global Village, we all ought to take time to indulge in the joy of living. Consequently, make sure you live your dreams passionately, because I am not at all sure that there is another reincarnation awaiting us. And even if there is, what if it is your turn, or mine, to be a rat the next time!